What happened the last time small caps looked pricey?

Summary: Small-cap funds are on fire again, with valuations stretching well above their seven-year average. But the last time small caps overheated in 2018, investors were left nursing losses. We break down what happened then, what fund managers are saying and what it all means for your investments today.

The Nifty Smallcap 250 TRI is trading at a price-to-earnings (P/E) multiple of 35, as of July 2025, higher than its seven-year average of 31. That hasn’t deterred investors, though, as small-cap funds have emerged as the second most popular equity fund category this year, behind only flexi caps.

But with valuations stretching and money pouring in, the obvious question is: are we entering frothy territory? To answer that, it’s worth revisiting the last time small caps overheated.

The last froth: 2018

In early 2018, the small-cap index traded at a jaw-dropping P/E of 70. That euphoria quickly turned painful.

• Between January 2018 and December 2019, the Nifty Smallcap 250 TRI fell 17.5 per cent.
• Investors in small-cap funds had little to cheer about either. Thirteen of the 14 active small-cap funds delivered negative returns in this period.
• Only Axis Small Cap Fund managed to buck the trend.
• Last but not least, 10 of the small-cap funds lost over 10 per cent during the 2018-19 period.

That episode is a reminder that when valuations run too hot, small-caps can burn investors badly.

Are we there yet?

So, are we reliving 2018? Not quite. The current P/E of 35 is above average, but nowhere close to the dizzying heights of 70.

Fund managers, too, are cautious but not alarmed.

Kirti Dalvi, Fund Manager at Mahindra Manulife Mutual Fund, put it succinctly: “Valuations are currently elevated, not only in India but also in several global markets. Does that make me cautious? Of course, yes, on a few stocks or sectors trading at high valuations, where the rally has already happened. But if you are paying a high P/E, it must be backed by high growth and strong visibility. Those are non-negotiable.”

The key, Dalvi emphasises, is the sustainability of growth. Paying up is fine if a company can deliver earnings visibility not just for two years, but for five or even 10 years. In other words, investors putting their money in small-cap funds need to believe that time in the market is better than timing the market.

Expensive… but maybe worth it

Another voice of perspective is Aditya Khemani, Fund Manager at Invesco Mutual Fund. He acknowledges the froth, but sees nuance in the numbers: “On an aggregate basis, I would say the market might be 20–25 per cent expensive. But valuation is always subjective. Looking at just the FY26 or FY27 P/E ratio and concluding that a stock is expensive is too narrow an exercise.”

Khemani points out that if you own companies capable of compounding earnings at 20 per cent CAGR for a decade, paying a 20–25 per cent premium upfront doesn’t necessarily hurt long-term returns.

In his words: “If earnings grow at 20 per cent CAGR over the next decade and you buy the stock 20–25 per cent expensive, your compounding could still be 17-18 per cent CAGR, quite close to the earnings growth.”

What it means for investors

• Valuations are elevated, but not at bubble levels. Unlike 2018, we are not staring at a P/E of 70.
• Time in the market matters. Small-cap investing is not about catching the next year’s rally, but staying invested for seven to ten years to ride out the volatility.
• Be prepared for turbulence. If valuations stretch further, short-term corrections are inevitable. The key is not to panic and exit at the first sign of red.

Our take

Small caps are bubbling, but the pot isn’t boiling over just yet. Investors must temper return expectations and remember that long-term compounding works in their favour.

While the last overheated phase hurt investors who chased momentum, the key is to stay disciplined and diversified. And if you’re investing in small-cap funds through SIPs (Systematic Investment Plans), do it with at least a 7–10 year horizon.

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Also read: Small-cap funds gave 5x returns in 10 yrs. A new normal?